1. © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 14: Company Analysis & Stock Valuation Analysis of Investments & Management of Portfolios Management of Portfolios 10 TH EDITION Reilly & Brown

2. Growth Companies & Growth Stocks Growth Companies –Historically, consistently experience above-average increases in sales and earnings –Theoretically, yield rates of return greater than the firm’s required rate of return Growth Stocks –Necessarily the stocks of growth companies –A growth stock has a higher rate of return than other stocks with similar risk –Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks 14-2 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Defensive Companies and Stocks Defensive Companies –The firms whose future earnings are more likely to withstand an economic downturn –Low business risk –No excessive financial risk –Typical examples are public utilities or grocery chains—firms that supply basic consumer necessities Defense Stocks –The rate of return is not expected to decline or decline less than the overall market decline –Stocks with low or negative systematic risk 14-3 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Cyclical Companies and Stocks Cyclical Companies –They are the companies whose sales and earnings will be heavily influenced by aggregate business activity –Examples would be firms in the steel, auto, or heavy machinery industries. Cyclical Stocks –They will have greater changes in rates of return than the overall market rates of return –They would be stocks that have high betas. 14-4 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Speculative Companies and Stocks Speculative Companies –They are the firms whose assets involve great risk but those that also have a possibility of great gain –A good example of a speculative firm is one involved in oil exploration Speculative Stocks –Stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return –For example, an excellent growth company whose stock is selling at an extremely high P/E ratio 14-5 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Value versus Growth Investing Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued Value stocks appear to be undervalued for reasons besides earnings growth potential Value stocks usually have low P/E ratio or low ratios of price to book value 14-6 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Company Analysis Firm’s Overall Strategic Approach –Industry competitive environment –SWOT analysis  Strengths  Weaknesses  Opportunities  Threats Firm’s Valuation Approaches –Present value of cash flows –Relative valuation ratio techniques 14-7 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Firm Competitive Strategies Porter suggests two major strategies: –Low-Cost Strategy  The firm seeks to be the low-cost producer, and hence the cost leader in its industry  Cost advantages vary by industry and might include economies of scale, proprietary technology, or preferential access to raw materials –Differentiation Strategy  Firm positions itself as unique in the industry in an area that is important to buyers  A company can attempt to differentiate itself based  on its distribution system or some unique marketing approach 14-8 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. SWOT Analysis Internal Analysis –Strengths  Give the firm a comparative advantage in the marketplace  Perceived strengths can include good customer service, high-quality products, strong brand  image, customer loyalty, innovative R&D, market leadership, or strong financial resources –Weaknesses  Weaknesses result when competitors have potentially exploitable advantages over the firm 14-9 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. SWOT Analysis External Analysis –Opportunities  These are environmental factors that favor the firm  They may include a growing market for the firm’s products (domestic and international), shrinking competition, favorable exchange rate shifts, or identification of a new market or product segment –Threats  They are environmental factors that can hinder the firm in achieving its goals  Examples would include a slowing domestic economy, additional government regulation, an increase in industry competition, threats of entry, etc 14-10 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Some Lessons from Peter Lynch Favorable Attributes of Firms –Firm’s product should not be faddish –Firm should have some long-run comparative advantage over its rivals –Firm’s industry or product has market stability –Firm can benefit from cost reductions –Firms that buy back shares show there are putting money into the firm 14-11 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Tenets of Warren Buffet 14-12 Business Tenets –Is the business simple and understandable? –Does the business have a consistent operating history? –Does the business have favorable long-term prospects? Management Tenets –Is management rational? –Is management candid with its shareholders? –Does management resist the institutional imperative? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Tenets of Warren Buffet 14-13 Financial Tenets –Focus on return on equity, not earnings per share –Calculate “owner earnings” –Look for companies with high profit margins –For every dollar retained, make sure the company has created at least one dollar of market value Market Tenets –What is the value of the business? –Can the business be purchased at a significant discount to its fundamental intrinsic value? © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Estimating Intrinsic Value Present value of cash flows (PVCF) –Present value of dividends (DDM) –Present value of free cash flow to equity (FCFE) –Present value of free cash flow (FCFF) Relative valuation techniques –Price earnings ratio (P/E) –Price cash flow ratios (P/CF) –Price book value ratios (P/BV) –Price sales ratio (P/S) 14-14 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Present Value of Dividends Simplifying assumptions help in estimating present value of future dividends Constant Growth DDM Intrinsic Value = D 1 /(k-g) and D 1 = D 0 (1+g) Growth Rate Estimates –Average Dividend Growth Rate –Sustainable Growth Rate g = RR X ROE 14-15 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. Present Value of Dividends Required Rate of Return Estimate –Nominal risk-free interest rate –Risk premium –Market-based risk estimated from the firm’s characteristic line using regression E(R stock ) = E(RFR) + β stock [E(R market ) – E(RFR)] 14-16 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Present Value of Dividends The Present Value of Dividends Model (DDM) –Model requires k>g –With g>k, analyst must use multi-stage model –The three-stage model example of the DDM approach in the book illustrates how to estimate the stock price experiences:  High growth at 13% for 3 years  Low growth rate of 1% for 6 years  Constant perpetual growth of 6% 14-17 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Present Value of Free Cash Flow to Equity Computing the FCFE FCFE =Net Income + Depreciation Expense - Capital Expenditures -  in Working Capital - Principal Debt Repayments + New Debt Issues 14-18 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Present Value of Free Cash Flow to Equity The Constant Growth Formula where: FCFE = the expected free cash flow in period 1 k = the required rate of return on equity for the firm g FCFE = the expected constant growth rate of free cash flow to equity for the firm A multi-stage model similar to DDM can also be applied 14-19 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Present Value of Operating Free Cash Flow Discount the firm’s operating free cash flow to the firm (FCFF) at the firm’s weighted average cost of capital (WACC) Computing FCFF FCFF =EBIT (1-Tax Rate) + Depreciation Expense - Capital Spending -  in Working Capital -  in other assets 14-20 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Present Value of Operating Free Cash Flow The Formula where: FCFF 1 = the free cash flow in period 1 OFCF 1 = the firm’s operating free cash flow in period 1 WACC = the firm’s weighted average cost of capital g FCFF = the constant growth rate of free cash flow g OFCF = the constant growth rate of operating free cash flow 14-21 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Present Value of Operating Free Cash Flow An alternative measure of long-run growth g = (RR)(ROIC) where: RR = the average retention rate ROIC = EBIT (1-Tax Rate)/Total Capital Computation of WACC WACC=W E k + W D i where: W E = the proportion of equity in total capital k = the after-tax cost of equity (from the SML) W D = the proportion of debt in total capital i = the after-tax cost of debt 14-22 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Relative Valuation Ratio Techniques The general relative valuation ratio techniques have been discussed in the previous chapters Exhibit 14.3 contains the basic data required to compute the relative valuation ratios Exhibit 14.4 contains the four sets of relative valuation ratios for Walgreens, its industry, and the aggregate market 14-23 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Estimating Company Earnings Per Share A Two-Step Process –Sales Forecast  It includes an analysis of the relationship of company sales to various relevant economic series  It also includes a comparison with the industry series –Estimated Profit Margin  Identification and evaluation of the firm’s specific competitive strategy  The firm’s internal performance  The firm’s relationship with its industry 14-24 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

25. Walgreens Competitive Strategies The Internal Performance –Industry Factors –Company Performance –Net Profit Margin Estimate –Computing Earnings per Share Importance of Quarterly Estimates –A way to confirm our annual estimate –If the actual quarterly results are a surprise relative to our estimate, we will want to understand the reason for the surprise 14-25 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Estimating Company Earnings Multipliers Macroanalysis of the Earnings Multiplier Microanalysis of the Earnings Multiplier –Comparing dividend-payout ratios –Estimating the required rate of return –Estimating the expected growth rate –Computing the earnings multiplier –Estimates of intrinsic value for Walgreens 14-26 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Additional Measures of Relative Value Price/Book Value Ratio –Book value is a reasonable measure of value for firms that have consistent accounting practice –It can been applied to firms with negative earnings or cash flows –Should not attempt to use this ratio to compare firms with different levels of hard assets—for example, a heavy industrial firm and a service firm –See Walgreens in Exhibits 14.16 & 14.17 14-27 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. Additional Measures of Relative Value Price/Cash Flow Ratio –The price/cash flow ratio has grown in prominence and use because many observers contend that a firm’s cash flow is less subject to manipulation –See Walgreens in Exhibits 14.18 & 14.19 Price-to-Sales Ratio –Sales growth drives the growth of all subsequent earnings and cash flow and sales is one of the purest numbers available –See Walgreens in Exhibits 14.20 & 14.21 14-28 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29. Analysis of Growth Companies Generating rates of return greater than the firm’s cost of capital is considered to be temporary Earnings higher the required rate of return are pure profits How long can they earn these excess profits? Is the stock properly valued? Growth companies and the DDM –No growth firms –Long-run growth models 14-29 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. No-Growth Firm A No-Growth Firm –E = r x Assets –E = r x Assets = Dividends (Firms has retention ratio, b, of 0) Firm Value Required Rate of Return 14-30  k Eb k E V   1 v E k  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

31. Long-Run Growth Models Simple Growth Model –It assumes the firm has growth investment opportunities that provide rates of return equal to r, where r is greater than k –r=mk (m is the relative rate of return operator) –D=E (1-b) –Gross Present Value of Growth Investments –Net Present Value of Growth Investments 14-31 k bEm k bEmk  2 k bE k bEm  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32. Long-Run Growth Models Simple Growth Model (continued) –Firm Value –PV of Constant Dividend + PV of Growth Investment –PV of Constant Earnings + PV of Excess Earnings from Growth Investment 14-32  k mbE k E V 1   k bEm k D V  k bE k bEm k E V  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

33. Long-Run Growth Models Expansion Model –Firm retains earnings to reinvest, but receives a rate of return on its investment equal to its cost of capital –In this case, m = 1 so r = k –Firm Value  Recall the simple growth model  When m=1 14-33 k (m(mbE k E V 1)   k E V  © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

34. Long-Run Growth Models Negative Growth Model –Firm retains earnings, but reinvestment returns are below the firm’s cost of capital. That is, r 1 –Since growth will be positive (r>0) but slower than it should be (r<k), the value will decline when the investors discount the reinvestment stream at the cost of capital 14-34 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

35. Long-Run Growth Models The Capital Gain Component –The gross present value of growth investments bEm / k –The three factors that influence the capital gain component:  The amount of capital invested in growth investments (b)  The relative rate of return earned on the funds retained (m)  The time period for these growth investments 14-35 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36. Long-Run Growth Models Dynamic True Growth Model –Firm invests a constant percentage of current earnings in projects that generate rates of return above the firm’s required rate of return –In this case, r>k and m>1 –Firm value for the dynamic growth model for an infinite time period 14-36 gk D V   1 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

37. Measures of Value-Added Economic Value-Added (EVA) –It is equal to the net operating profit less adjusted taxes (NOPLAT) minus the firm’s total cost of capital in dollar terms, including the cost of equity EVA Return on Capital –EVA/Capital –This ratio can compare firms of different sizes and determine which firm has the largest economic profit per dollar of capita Alternative Measure of EVA –Compare return on capital to cost of capital 14-37 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

38. Measures of Value-Added Market Value-Added (MVA) –Measure of external performance –How the market has evaluated the firm’s performance in terms of market value of debt and market value of equity compared to the capital invested in the firm Relationships between EVA and MVA –mixed results 14-38 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

39. Measures of Value-Added The Franchise Factor –Breaks P/E into two components  P/E based on ongoing business (base P/E)  Franchise P/E the market assigns to the expected value of new and profitable business opportunities Franchise P/E = Observed P/E - Base P/E –Incremental Franchise P/E = Franchise Factor X Growth Factor where R= the expected return on the new opportunities k=the current cost of equity r = the current ROE on investment G= the PV of the new growth projects relative to the current value of the firm 14-39 G rk kR    © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

40. Growth Duration Model The purpose is to evaluate the high P/E ratio for the stock of a growth company by relating its P/E ratio to the firm’s rate of growth and duration of growth A stock’s P/E is function of –expected rate of growth of earnings per share –stock’s required rate of return –firm’s dividend-payout ratio The growth estimate must consider both the rate of growth and how long this growth rate can be sustained—that is, the duration of the expected growth rate 14-40 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

41. Intra-Industry Analysis Directly compare two firms in the same industry An alternative use of T to determine a reasonable P/E ratio Factors to consider –A major difference in the risk involved –Inaccurate growth estimates –Stock with a low P/E relative to its growth rate is undervalued –Stock with high P/E and a low growth rate is overvalued 14-41 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

42. Site Visits and the Art of the Interview Focus on management’s plans, strategies, and concerns Restrictions on nonpublic information “What if” questions can help gauge sensitivity of revenues, costs, and earnings Management may indicate appropriateness of earnings estimates Discuss the industry’s major issues Review the planning process Talk to more than just the top managers 14-42 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

43. When to Sell Holding a stock too long may lead to lower returns than expected If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis? Continuously monitor key assumptions Evaluate closely when market value approaches estimated intrinsic value Know why you bought it and watch for that to change 14-43 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

44. Influences on Analysts Efficient Markets –In most instances, the value estimated for a stock will be very close to its market price, which indicates that it is properly valued Paralysis of Analysis –To earn above-average returns, there are two requirements: (1) the analyst must have expectations that differ from the consensus, and (2) the analyst must be correct Analyst Conflicts of Interest –A potential conflict can arise if communication occurs between a firm’s investment banking and equity research division 14-44 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

45. Global Company and Stock Analysis Availability of Data Differential Accounting Conventions Currency Differences (Exchange Rate Risk) Political (Country) Risk Transaction Costs and Liquidity Valuation Differences 14-45 © 2012 Cengage Learning. All Rights Reserved. May not scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.